If you could predict where inflation would be during 2018, you’d have a good idea of where long-term interest rates will head, how monetary policy is likely to develop, and therefore how the equity and bond markets are likely to perform. With that information, you could make an informed decision about asset allocation within your portfolio.
In a recently released article by the Federal Reserve Bank of San Francisco, economists Tim Mahedy and Adam Shapiro took a stab at analyzing the underlying cause of the persistently low inflation we’ve seen since the end of the financial crisis.
To refresh your memory, the Federal Reserve has been unable to hit its 2% core PCE inflation target for a number of years. During this time, they’ve utilized just about every tactic they have for boosting inflation – forward guidance, lowering rates to zero, adding rounds of quantitative easing – and although the economy has been performing strongly, inflation has largely remained absent.
Why is this? Is the link between economic growth and inflation broken? Or is there another alternative that explains this phenomenon?
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When it comes to predicting inflation, many economists still believe that the Philips curve plays a strong role. The Philips curve posits that there is an inverse relationship between unemployment and inflation … that is, when unemployment is low and the labor market is tight, high demand relative to supply will push prices higher. Said differently, strong economic growth begets higher inflation.
But this makes the assumption that most categories of prices in our economy are procyclical – that they move in tandem with the economic cycle. New research by the Federal Reserve Bank of San Francisco suggests this may not actually be the case.
In an attempt to better understand the drivers of persistently low inflation, Mahedy and Shapiro broke apart the PCE to create Philips curve models of inflation by pricing category. As they did this, they stumbled upon some rather unique data that is relevant to both economists and investors.
What Mahedy and Shapiro found is that of all the categories of prices tracked by the PCE, only 42% of them exhibited a procyclical relationship with the economy. That is, only 42% of the PCE respond the way that the Philips curve would predict. These procyclical categories include housing, recreational services, food services and some nondurable goods.
This means that the rest of the PCE (58%) is actually comprised of non-cyclical pricing categories – these prices show no statistically significant historical positive relationship with economic growth. If you think about it, that’s actually a rather startling finding, as it suggests that the primary factors driving inflation are unrelated to economic growth.
With the PCE effectively broken apart into its pro-cyclical and acyclical sectors, Mahedy and Shapiro were able to plot the relative contributions of these two groups together on one chart (shown below).
Notice that during some periods, procyclical and acyclical categories move in sync, either rising together or falling together, but during other periods – most recently from 2014 on – the two series move in opposite directions.
During the last three years, procyclical pricing categories have indeed responded to a tightening labor market and improved economic growth, and have actually risen above the Fed’s 2% inflation target.
But acyclical categories, on the other hand, have shown relatively weak inflation, and are a primary reason why overall core inflation has remained below 2%. These categories, which include health-care services, financial services, clothing and transportation, among others, are effectively acting as dead weights, holding back the cyclical forces of inflation.
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Wanting to understand which of the acyclical categories was having the largest effect on dampening overall inflation, Mahedy and Shapiro dug deeper into the data and found a major culprit: healthcare services.
Healthcare currently accounts for roughly 35% of a cyclical inflation and approximately 20% of the entire core PCE index. As a result, it plays an outsized role in how the Fed’s preferred measure of inflation performs from one month to the next.
And inflation in healthcare services has been largely absent. In fact, healthcare has actually been a drag on overall inflation for quite some time.
This next chart shows the impact that healthcare services have had on inflation over the past few years, in relation to the effect of other acyclical categories. The blue bars represent how much of the acyclical deviation is attributable to healthcare services, while the red bars show contributions from the other acyclical categories.
The big takeaway here is that healthcare services have been acting as a major drag on core inflation. Averaging approximately 3.5% during the mid-2000’s, healthcare services has seen average inflation of only 1.1% over the past 5 years.
Altogether, this means that healthcare is currently contributing about 0.3% less to core PCE than in the pre-Great Recession years. If healthcare inflation was averaging the same rate it did in the run-up to the financial crisis, the Fed would, in fact, have achieved its 2% core inflation target.
This analysis naturally leads to the questions of why healthcare services have seen such low inflation, and whether that low inflation is likely to persist.
Without going into too much detail, the authors found that legislated changes to Medicare payments are likely the driving cause. Through the Affordable Care Act and other legislation, the federal government has effectively limited how quickly a significant chunk of healthcare costs can rise. This, in turn, has influenced the rate of payment growth across private insurers.
Medicare payments are scheduled to rise by 2.0% during 2018 (up from 0.9% during 2016 and 0.6% during 2017) but even this bump up in price inflation is unlikely to have a major impact on overall core inflation. For that, we would need to see healthcare services inflation return to near its pre-crisis levels of 3.5%.
Given that healthcare services inflation is likely to remain low, continuing to act as a drag on the procyclical forces of inflation, it’s very likely that overall core PCE inflation will remain subdued as well.
This means that 2018 could see inflationary forces that are quite similar to what we saw in 2017, even if the economy continues to perform well.
Translating this back into the outlook for market prices, it suggests that longer-term interest rates – which provide little more than inflation compensation these days (no risk premium) – are likely to remain low during 2018. As a result, there are a good chance bond prices will remain elevated.
If this scenario does play out, and interest rates to stay low, then bonds will continue to provide little competition to stocks, which do stand to benefit heavily from economic growth. Altogether, this suggests that investors will benefit most by allocating the majority of their investments towards equities during 2018.
Of course, there are many factors beyond inflation that will impact asset prices this year but, based on the current outlook, the overall stock market remains a good bet moving forward.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
